What is an Exchange Traded Fund?

Exchange-Traded Funds (or ‘ETFs’ for short), are a popular method for investing in a wide range of asset classes. In the US alone, $4 trillion of assets are now held in ETFs.

But what is an ETF and what are the benefits of using an ETF compared to another type of fund?

Definition of an ETF

An Exchange Traded Fund is a fund which is listed on the stock market much like any company.

A fund is a collective investment scheme. It will purchase investments according to its investment strategy, and therefore shareholders of the ETF, will indirectly own the underlying assets.

ETFs will pay dividends on a regular basis in accordance with their policy. If the ETF is labelled as ‘Acc’ this means that their policy is to accumulative and reinvest dividends into the underlying assets instead. Distributing funds are labelled ‘Dist’, such as in the image below.

What is an ETF
The fund name will usually state whether the fund pays dividends (Dist) or reinvests (Acc)

Advantages of an ETF

Investors can buy shares in an ETF at any point during trading hours (8:00 – 16:30) using their choice of stockbroker. Those trades will incur the same trading fees as the purchase of shares in an individual company.

This is an advantage over traditional mutual funds (technical names: unit trusts or open-ended investment companies). These schemes usually have a single trade-point per day with a single price.

ETFs are more ‘liquid’ than mutual funds, because investors are trading directly with other investors over a stock exchange, rather than with the fund itself. This means that the fund doesn’t need to worry about liquidating its holdings to be able to satisfy a large withdrawal – the dissatisfied investor simply sells their shares to another investor.

A mutual fund must manage the demands of money flows itself. If it cannot raise enough cash to pay a withdrawal, they may be forced to halt withdrawals from the fund while they sell underlying assets. This leaves all investors locked out and unable to access their cash until the fund opens again.

What is an ETF - Angry customers are sometimes unable to access their investments in a fund
Investors in the Woodford Income Trust were locked out in 2019 when the fund was unable to fulfil withdrawal requests.

What is the largest ETF in the world?

The largest ETF in the world is the SPDR S&P 500 ETF, which invests in the S&P 500 (A US index of large companies).

A stockbroker will usually charge more for international trades than domestic trades.

Therefore, to reduce investing costs, an investor based outside of the US could invest in a localised version such as the SPDR S&P 500 UCITS ETF which is tailored to British investors.

How does an ETF work?

Buying shares in an ETF is a simple process. It is an exchange of existing shares between two investors via stockbrokers and a marketplace.

But ETFs also do something else that makes them quite distinct from ordinary companies.

ETFs also create and destroy shares in a fluid way throughout the day. They do this to ensure that the market value of the ETF remains close to the underlying value of the assets held in the fund (known as the NAV).

What is an ETF - ETFs create shares

Why is a share creation process needed

Let’s look at an example of this share creation process to understand how and why it works.

Imagine that a tiny ETF holds 100 shares in Coca Cola Enterprises (worth $10 each). This portfolio is currently worth $1,000.

Let’s assume that the ETF itself is comprised of 10 shares. Therefore the holder of an ETF share owns 10 Coca Cola shares indirectly.

If common sense applies, then each ETF share is worth $100, and the total ETF should be worth $1,000 – matching the value of its underlying portfolio.

Next, a flurry of investors buys shares in the ETF because it was featured on a TV commercial.

When buyers outnumber sellers, the price of a security will increase. This is because after buying all of the shares offered on the market at the lowest price, the further buyers will need to bid higher to convince the next investor to sell).

So perhaps because of this buying activity, the ETF shares creep up to $105 each. This values the fund at $1,050 overall. This is a problem.

The issue is that the value of the fund is still objectively worth $1,000 because, in this example, the value of 100 Coca Cola shares has remained the same.

No investor would want to buy into the fund, because they’d be paying $105 for $100 worth of Coca Cola shares. There’s no reason why they need to pay a premium – they have the option of buying $100 of Coca Cola shares via their stockbroker instead.

ETFs have a share creation process to ensure that the ETF price falls back in line quickly so that trading can resume.

How the share creation process works

Large financial institutions are permitted to ask for new shares in the fund to be created. Instead of buying these shares with cash, the institution must pay with the equivalent basket of assets that sit behind an existing share.

In this case, each ETF share is represented by 10 Coca Cola shares, so the institution must provide 10 Coca Cola shares to the ETF, and in exchange, they will be handed a brand new ETF share.

The institution paid $100 to buy the underlying Coca Cola shares, and now has an ETF unit which was recently trading at $105. Therefore they will immediately sell that ETF share on the market. This process can be repeated as many times as the institution wants.

The effect of the institution selling all these new ETF shares is that the price will begin to fall, as the selling now outweighs the buying. When the ETF price equalises at $100, the institution will no longer make a profit from this ‘arbitrage’, so will stop.

It’s quite a clever process because it’s the self-interest of the institution that leads the ETF market price to automatically correct back to its NAV value.

To explain this process in an intuitive way – an ETF can increase in size when demand is high, and shrink when demand is low. It always does so with the perfect speed to ensure that the price is never pushed far from the underlying NAV value for more than a few moments.

The effect of the share creation process

The overall effect is that shareholders can trust that the value of an ETF will always closely match its underlying assets.

This lowers the risk that their returns will become somehow disconnected from the real assets contained in the fund.

This sounds like a basic thing to expect of a fund, but this is not the case.

Other types of funds, such as investment trusts have no such mechanism. As a result, their share prices can trade at a large discount or premium to their underlying NAV for long periods.

This increases risk to investors, who now have to worry about the risk of the underlying asset AND the risk of a change in the premium or discount.

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